Highlands Bankshares (HBSI) 10-Q 2010 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

x  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2010.

¨  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number:  0-16761

HIGHLANDS BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

West Virginia	55-0650793
(State or Other Jurisdiction of Incorporation or Organization)	(IRS Employer Identification No.)

P.O. Box 929

Petersburg, WV 26847

(Address of Principal Executive Offices, Including Zip Code)

304-257-4111

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this Chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ¨No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filed, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer ¨   Accelerated Filer    ¨   Non-accelerated filer     ¨ (Do not check if a smaller reporting company) Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   ¨ Yesx No

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date. As of August 12, 2010:  1,336,873 shares of Common Stock, $5 Par Value

HIGHLANDS BANKSHARES, INC.

Quarterly Report on Form 10-Q For The Period Ended June 30, 2010

	INDEX
		Page
PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Unaudited Consolidated Statements of Income
	Six Months Ended June 30, 2010 and 2009	1
	Unaudited Consolidated Statements of Income
	Three Months Ended June 30, 2010 and 2009
	Unaudited Consolidated Balance Sheet for June 30, 2010
	and Audited Consolidated Balance Sheet for December 31, 2009	3
	Unaudited Consolidated Statements of Changes in Stockholders’
	Equity for the Six Months Ended June 30, 2010 and 2009	4
	Unaudited Consolidated Statements of Cash Flows for the Six
	Months Ended June 30, 2010 and 2009	5
	Notes to Consolidated Financial Statements	6
Item 2.	Management’ Discussion and Analysis of Financial Condition
	and Results of Operations	11
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	24
Item 4.	Controls and Procedures	24
PART II	OTHER INFORMATION
Item 1.	Legal Proceedings	25
Item 1A.	Risk Factors	25
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	25
Item 3.	Defaults Upon Senior Securities	25
Item 4.	(Removed and Reserved)	25
Item 5.	Other Information	25
Item 6.	Exhibits	25
SIGNATURES		26

PART I.

Item 1. Financial Statements

HIGHLANDS BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME

(In Thousands of Dollars, Except Per Share Data)

	Six Months Ended June 30
	2010			2009
	(unaudited)			(unaudited)
Interest Income
Interest and fees on loans	$	11,112		$	11,701
Interest on federal funds sold		10			9
Interest on deposits in other banks		3			6
Interest and dividends on securities		374			444
Total Interest Income		11,499			12,160
Interest Expense
Interest on deposits		3,096			3,710
Interest on borrowed money		239			269
Total Interest Expense		3,335			3,979
Net Interest Income		8,164			8,181
Provision for Loan Losses		2,305			821
Net Interest Income After Provision for Loan Losses		5,859			7,360
Non-interest Income
Service charges		755			806
Life insurance investment income		132			123
Gains (losses) on securities transactions		33			(13	)
Gains (losses) on sale of foreclosed property		(35	)		1
Other non-interest income		182			230
Total Non-interest Income		1,067			1,147
Non-interest Expense
Salaries and employee benefits		3,445			3,257
Occupancy and equipment expense		728			672
Data processing expense		545			339
Directors fees		187			185
Legal and professional fees		318			228
Other non-interest expense		1,152			1,295
Total Non-interest Expense		6,375			5,976
Income Before Provision For Income Taxes		551			2,531
Provision for Income Taxes		160			908
Net Income	$	391		$	1,623
Per Share Data
Net Income	$	0.29		$	1.21
Cash Dividends	$	0.54		$	0.58
Weighted Average Common Shares Outstanding		1,336,873			1,336,873

The accompanying notes are an integral part of these financial statements.

1

HIGHLANDS BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME

(In Thousands of Dollars, Except Per Share Data)

	Three Months Ended June 30
	2010			2009
	(unaudited)			(unaudited)
Interest Income
Interest and fees on loans	$	5,629		$	5,811
Interest on federal funds sold		5			4
Interest on deposits in other banks		1			3
Interest and dividends on securities		187			217
Total Interest Income		5,822			6,035
Interest Expense
Interest on deposits		1,490			1,872
Interest on borrowed money		124			132
Total Interest Expense		1,614			2,004
Net Interest Income		4,208			4,031
Provision for Loan Losses		1,213			537
Net Interest Income After Provision for Loan Losses		2,995			3,494
Non-interest Income
Service charges		399			439
Life insurance investment income		66			61
Gains (losses) on securities transactions		0			0
Gains (losses) on sale of foreclosed property		(39	)		1
Other non-interest income		94			117
Total Non-interest Income		520			618
Non-interest Expense
Salaries and employee benefits		1,725			1,596
Occupancy and equipment expense		360			343
Data processing expense		274			170
Directors fees		88			82
Legal and professional fees		136			105
Other non-interest expense		594			790
Total Non-interest Expense		3,177			3,086
Income Before Provision For Income Taxes		338			1,026
Provision for Income Taxes		108			366
Net Income	$	230		$	660
Per Share Data
Net Income	$	0.17		$	0.49
Cash Dividends	$	0.27		$	0.29
Weighted Average Common Shares Outstanding		1,336,873			1,336,873

The accompanying notes are an integral part of these financial statements.

2

HIGHLANDS BANKSHARES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands of dollars)

	June 30, 2010			December 31, 2009
	(unaudited)			(audited)
ASSETS
Cash and due from banks	$	6,710		$	7,062
Interest bearing deposits in banks		1,824			1,880
Federal funds sold		7,631			8,936
Investment securities available for sale		30,926			26,936
Restricted investments		2,185			2,185
Loans		332,966			335,483
Allowance for loan losses		(5,416	)		(4,021	)
Bank premises and equipment, net of depreciation		9,783			9,326
Interest receivable		1,898			1,908
Investment in life insurance contracts		6,887			6,755
Foreclosed Assets		4,049			3,223
Goodwill		1,534			1,534
Other intangible assets		923			1,020
Other assets		5,208			5,583
Total Assets	$	407,108		$	407,810
LIABILITIES
Deposits
Non-interest bearing deposits	$	53,374		$	52,378
Interest bearing transaction and savings accounts		75,225			73,053
Time deposits over $100,000		75,577			75,596
All other time deposits		145,443			148,850
Total Deposits		349,619			349,877
Long term debt instruments		10,633			10,866
Accrued expenses and other liabilities		5,798			5,645
Total Liabilities		366,050			366,388
STOCKHOLDERS’ EQUITY
Common Stock, $5 par value, 3,000,000 shares
authorized, 1,436,874 shares  issued		7,184			7,184
Surplus		1,662			1,662
Treasury stock (100,001 shares, at cost)		(3,372	)		(3,372	)
Retained earnings		36,632			36,963
Other accumulated comprehensive loss		(1,048	)		(1,015	)
Total Stockholders’ Equity		41,058			41,422
Total Liabilities and Stockholders’ Equity	$	407,108		$	407,810

The accompanying notes are an integral part of these financial statements

3

HIGHLANDS BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(In Thousands of Dollars)

	Common Stock		Surplus		Treasury Stock			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total
Balances at December 31, 2008	$	7,184	$	1,662	$	(3,372	)	$	35,157		$	(1,232	)	$	39,399
Other Comprehensive Income:
Net Income									1,623						1,623
Change in other comprehensive income												73			73
Total Comprehensive Income															1,696
Dividends Paid									(775	)					(775	)
Balances June 30, 2009	$	7,184	$	1,662	$	(3,372	)	$	36,005		$	(1,159	)	$	40,320
Balances at December 31, 2009	$	7,184	$	1,662	$	(3,372	)	$	36,963		$	(1,015	)	$	41,422
Other Comprehensive Income:
Net Income									391						391
Change in other comprehensive income												(33	)		(33	)
Total Comprehensive Income															358
Dividends Paid									(722	)					(722	)
Balances June 30, 2010	$	7,184	$	1,662	$	(3,372	)	$	36,632		$	(1,048	)	$	41,058

The accompanying notes are an integral part of these financial statements

4

HIGHLANDS BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands of Dollars)

	Six Months Ended June 30,
	2010			2009
	(unaudited)			(unaudited)
Cash Flows From Operating Activities
Net Income	$	391		$	1,623
Adjustments to reconcile net income to net
cash provided by operating activities
Loss (gain) on securities transactions		(33	)		13
(Gain) loss on sale of OREO		35			(26	)
Depreciation		372			321
Change in insurance contracts		(121	)		(123	)
Net amortization of securities		68			(39	)
Provision for loan losses		2,305			821
Write-down of OREO		0			40
Deferred income tax benefit		(400	)		0
Amortization of intangibles		97			97
Decrease in interest receivable		10			181
(Increase) decrease in other assets		775			(71	)
Increase in accrued expenses and other liabilities		161			324
Net Cash Provided by Operating Activities		3,660			3,161
Cash Flows From Investing Activities
(Increase) decrease in federal funds sold		1,305			(12,886	)
Proceeds from maturities of securities available for sale		8,068			4,531
Purchase of securities available for sale		(12,145	)		(3,957	)
(Increase) in restricted investments		0			(8	)
Proceeds from sale of fixed assets and OREO		116			93
Decrease in interest bearing deposits in banks		56			71
Purchase of property and equipment		(829	)		(1,418	)
Net (increase) decrease in loans		630			(7,991	)
Net Cash (Used in) Investing Activities		(2,799	)		(21,565	)
Cash Flows From Financing Activities
Net change in time deposits		(3,426	)		17,724
Net change in other deposit accounts		3,168			5,933
Net change in short term borrowings		0			(4,800	)
Repayment of long term borrowings		(233	)		(222	)
Dividends paid in cash		(722	)		(775	)
Net Cash Provided by (used in) Financing Activities		(1,213	)		17,860
Net (decrease)  in Cash and Cash Equivalents		(352	)		(544	)
Cash and Cash Equivalents, Beginning of Period		7,062			7,589
Cash and Cash Equivalents, End of Period	$	6,710		$	7,045
Supplemental Disclosures
Cash paid for income taxes	$	0		$	831
Cash paid for interest	$	3,561		$	4,086

The accompanying notes are an integral part of these financial statements.

5

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE ONE: ACCOUNTING PRINCIPLES

The consolidated financial statements conform to U. S. generally accepted accounting principles and to general industry practices.  In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments, consisting solely of normal recurring adjustments, necessary to present fairly the financial position as of June 30, 2010 and the results of operations for the three and six month periods ended June 30, 2010 and 2009.

The results of operations for the three and six month periods ended June 30, 2010 and 2009 are not necessarily indicative of the results to be expected for the full year.

The notes included herein should be read in conjunction with the notes to financial statements included in the Company’s 2009 annual report on Form 10-K.

Certain reclassifications have been made to prior period balances to conform with the current years’ presentation format.

NOTE TWO: LOANS

A summary of loans outstanding as of June 30, 2010 and December 31, 2009 is shown in the table below (in thousands of dollars):

	June 30, 2010			December 31, 2009
Loan Type
Real Estate mortgage	$	163,279		$	162,619
Real Estate construction		32,727			30,759
Commercial		100,608			97,606
Installment		36,352			44,499
Total Loans	$	332,966		$	335,483
Allowance for loan losses	$	(5,416	)	$	(4,021	)

In addition to loans to fund construction and traditional mortgage loans, portions of the portfolio identified as commercial are also secured by real estate.  At June 30, 2010, the total balance of loans in the portfolio secured by real estate was $283,496,000.

NOTE THREE: ALLOWANCE FOR LOAN LOSSES

A summary of the transactions in the allowance for loan losses for the six month periods ended June 30, 2010 and 2009 is shown below (in thousands of dollars):

	2010			2009
Balance, beginning of period	$	4,021		$	3,667
Provisions charged to operations		2,305			821
Loan recoveries		274			131
Loan charge-offs		(1,184	)		(883	)
Balance, end of period	$	5,416		$	3,736

The following summary provides information regarding impaired loans as of June 30, 2010 and December 31, 2009 (in thousands of dollars):

	2010		2009
Period end balance, impaired loans	$	9,344	$	3,425
Allowance for impairments, period end		1,952		662

6

NOTE FOUR: INVESTMENT IN INSURANCE CONTRACTS

Investment in insurance contracts consist of single premium insurance contracts which have the dual purposes of providing a rate of return to the Company which approximately equals the Company’s average cost of funds and of providing life insurance and retirement benefits to certain executives.

NOTE FIVE: SECURITIES AND RESTRICTED INVESTMENTS

The Company’s securities portfolio serves several purposes. Portions of the portfolio secure certain public and trust deposits while the remaining portions are held as investments or used to assist the Company in liquidity and asset/liability management.

The amortized cost and market value of securities as of June 30, 2010 and December 31, 2009 is shown in the table below (in thousands of dollars). All of the securities on the Company’s balance sheet are classified as available for sale.

	June 30, 2010				December 31, 2009
	Amortized		Market		Amortized		Market
	Cost		Value		Cost		Value
Available For Sale Securities
U.S. Treasuries and Agencies	$	13,279	$	13,459	$	12,250	$	12,426
Mortgage backed securities		4,684		4,895		5,630		5,836
States and municipalities		3,365		3,435		3,832		3,946
Certificates of deposit		8,076		8,068		4,696		4,703
Marketable equities		1,056		1,069		15		25
Total Available For Sale Securities	$	30,460	$	30,926	$	26,423	$	26,936

Information pertaining to securities with gross unrealized losses at June 30, 2010 and December 31, 2009, aggregated by investment category and length of time that individual securities have been in a continuous loss position is shown in the table below (in thousands of dollars):

	Total					Less than 12 Months					12 Months or Greater
	Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses
June 30, 2010
Investment Category
U.S. Treasuries and Agencies		0		0			0		0			0		0
Mortgage backed securities		24		0			24		0			0		0
Certificates of deposit		3,592		(23	)		3,592		(23	)		0		0
Marketable equities		0		0			0		0			0		0
Total	$	3,616	$	(23	)	$	3,616	$	(23	)	$	0	$	0
December 31, 2009
Investment Category
U.S. Treasuries and Agencies		999		(1	)		999		(1	)		0		0
Mortgage backed securities		24		0			24		0			0		0
Certificates of deposit		246		(2	)		246		(2	)		0		0
Marketable equities		0		0			0		0			0		0
Total	$	1,269	$	(3	)	$	1,269	$	(3	)	$	0	$	0

7

Restricted investments consist of investments in the Federal Home Loan Bank, the Federal Reserve Bank and West Virginia Bankers’ Title Insurance Company.  Investments are carried at face value and the level of investment is dictated by the level of participation with each institution.  Amounts are restricted as to transferability. The Company’s investment in Federal Home Loan Bank (FHLB) stock totaled $2.0 million at June 30, 2010.  FHLB stock is generally viewed as a long term investment and as a restricted investment security, which is carried at cost, because there is no market for the stock other than the FHLBs or member institutions.  Therefore, when evaluating FHLB stock for impairment, its value is based on ultimate recoverability of the par value rather than by recognizing tem porary declines in value.  Despite the FHLB’s temporary suspension of cash dividend payments and repurchases of excess capital stock in 2009, the Company does not consider this investment to be other than temporarily impaired at June 30, 2010 and no impairment has been recognized.

NOTE SIX: EARNINGS PER SHARE

There have been no changes in the Company’s outstanding shares of common stock since the fourth quarter of 2008.

NOTE SEVEN: BORROWINGS

The Company has borrowed money from the Federal Home Loan Bank of Pittsburgh (FHLB). This debt consists of both borrowings with terms of maturities of six months or greater and also certain debts with maturities of thirty days or less.

The borrowings with long term maturities may have either single payment maturities or amortize. The interest rates on the various long term borrowings at June 30, 2010 range from 3.94% to 5.96%. The weighted average interest rate on the borrowings at June 30, 2010 was 4.61%.

In addition to utilization of the FHLB for borrowings of long term debt, the Company also can utilize the FHLB for overnight and other short term borrowings. At June 30, 2010 and December 31, 2009, the Company had no overnight or other short term borrowings.

NOTE EIGHT: INTANGIBLE ASSETS

The Company’s balance sheet contains several components of intangible assets. At June 30, 2010, the total balance of intangible assets was comprised of Goodwill and Core Deposit Intangible Assets acquired as a result of the acquisition of other banks and also an intangible asset related to the purchased naming rights for a performing arts center located within the Company’s primary business area. The Company performs an impairment test on an annual basis.  No impairment has been recorded to date.

NOTE NINE: EMPLOYEE BENEFITS

The Company's two subsidiary banks each have separate retirement and profit sharing plans which cover substantially all full time employees at each bank.

Capon Valley Bank has a defined contribution pension plan with 401(k) features that is funded with discretionary contributions by the Bank.  The bank matches on a limited basis the contributions of the employees.  Investment of employee balances is done through the direction of each employee.  Employer contributions are vested over a six year period.

The Grant County Bank is a member of the West Virginia Bankers' Association Retirement Plan.  Benefits under the plan are based on compensation and years of service with 100% vesting after seven years of service. The bank was required to make contributions in 2006, 2007 and 2008 and made a contribution of $589,000 in the third quarter of 2009. The Bank has recognized liabilities of $1,404,000 at June 30, 2010. The following table provides the components of the net periodic benefit cost for the plan for the six month periods ended June 30, 2010 and 2009 (in thousands of dollars):

	2010			2009
Service cost	$	94		$	84
Interest cost		152			138
Expected return on plan assets		(169	)		(153	)
Recognized net actuarial loss		49			36
Amortization of unrecognized prior service costs		0			0
Net periodic expense	$	126		$	105

8

NOTE TEN: FAIR VALUE MEASUREMENTS

ASC 820, Fair Value Measurements and Disclosures (previously SFAS No. 157, Fair Value Measurements), defines fair value, establishes a framework for measuring fair value, establishes a three-level valuation hierarchy for disclosure of fair value measurement and enhances disclosure requirements for fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follow:

· Level One: Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

· Level Two: Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

· Level Three: Inputs to the valuation methodology are unobservable and significant to the fair value measurement.

Following is a description of the valuation methodologies used for instruments measured at fair value on the Company’s balance sheet, as well as the general classification of such instruments pursuant to the valuation hierarchy:

The Company, at June 30, 2010 and December 31, 2009 had no liabilities subject to fair value reporting requirements. The table below summarizes assets at June 30, 2010 and December 31, 2009 measured at fair value on a recurring basis (in thousands of dollars):

							Total Fair Value
30-Jun-10	Level 1		Level 2		Level 3		Measurements
U.S. Treasuries and Agencies	$	0	$	13,459	$	0	$	13,459
Mortgage backed securities		0		4,895		0		4,895
States and municipalities		0		3,435		0		3,435
Certificates of deposit		0		8,068		0		8,068
Marketable equities		0		1,069		0		1,069
Total Available For Sale Securities	$	0	$	30,926	$	0	$	30,926
								Total Fair Value
31-Dec-09	Level 1		Level 2		Level 3		Measurements
U.S. Treasuries and Agencies	$	0	$	12,426	$	0	$	12,426
Mortgage backed securities		0		5,836		0		5,836
States and municipalities		0		3,946		0		3,946
Certificates of deposit		0		4,703		0		4,703
Marketable equities		0		25		0		25
Total Available For Sale Securities	$	0	$	26,936	$	0	$	26,936

Where quoted prices are available in an active market, securities are classified within level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flow. Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within level 3 of the valuation hierarchy.  Currently, all of the Company’s securitie s are considered to be Level 2 securities.

The table below summarizes assets at June 30, 2010 and December 31, 2009, measured at fair value on a non recurring basis (in thousands of dollars):

							Total Fair Value
30-Jun-10	Level 1		Level 2		Level 3		Measurements
Other real estate owned	$	0	$	4,049	$	0	$	4,049
Impaired Loans		0		921		6,470		7,391
Total	$	0	$	4,970	$	6,470	$	11,440
31-Dec-09	Level 1		Level 2		Level 3		Total Fair Value Measurements
Other real estate owned	$	0	$	3,223	$	0	$	3,223
Impaired Loans		0		602		2,161		2,763
Total	$	0	$	3,825	$	2,161	$	5,986

9

Certain assets such as other real estate owned (OREO) are measured at fair value less cost to sell. Management believes that the fair value component in its valuation follows the provisions of ASC 820. Management estimates the fair value of real estate acquired through foreclosure at an estimated fair value less costs to sell. At or near the time of foreclosure, the subsidiary banks obtain real estate appraisals on the properties acquired through foreclosure. The real estate is then valued at the lesser of the appraised value or the loan balance, including interest receivable, at the time of foreclosure less an estimate of costs to sell the property. The estimate of costs to sell the property is based on historical transactions at the subsidiary banks of similar holdings.

ASC 820 applies to loans measured for impairment using the practical expedients permitted by Generally Accepted Accounting Pronouncements (“GAAP”), including impaired loans measured at an observable market price (if available), or at the fair value of the loan’s collateral (if the loan is collateral dependent). Fair value of the loan’s collateral, when the loan is dependent on collateral, is determined by appraisals or independent valuation which is then adjusted for the cost related to liquidation of the collateral. The impairment of loans is measured by the Company based on the estimated value of underlying collateral of the loan. The value of the collateral is typically based on either an appraisal of the collateral or management’s best estimation of the realizable value of the collateral, less est imated costs to sell.

The information above discusses financial instruments carried on the Company’s balance sheet at fair value. Other financial instruments on the Company’s balance sheet, while not carried at fair value, do have market values which may differ from the carrying value. GAAP requires disclosure relating to these market values. The following information shows the carrying values and estimated fair values of financial instruments and discusses the methods and assumptions used in determining these fair values.

The fair value of the Company's assets and liabilities is influenced heavily by market conditions. Fair value applies to both assets and liabilities, either on or off the balance sheet.  Fair value is defined as the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale.

The methods and assumptions detailed below were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value are discussed following:

Cash, Due from Banks and Money Market Investments

The carrying amount of cash, due from bank balances, interest bearing deposits and federal funds sold is a reasonable estimate of fair value.

Securities

Fair values of securities are based on quoted market prices or dealer quotes.  If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

Restricted Investments

The carrying amount of restricted investments is a reasonable estimate of fair value.

Loans

The fair value of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities, taking into consideration the credit risk in various loan categories.

Deposits

The fair value of demand, interest checking, regular savings and money market deposits is the amount payable on demand at the reporting date.  The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.

Long Term Debt

The fair value of fixed rate loans is estimated using the rates currently offered by the Federal Home Loan Bank for indebtedness with similar maturities.

Short Term Debt

The fair value of short-term variable rate debt is deemed to be equal to the carrying value.

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Interest Payable and Receivable

The carrying value of amounts of interest receivable and payable is a reasonable estimate of fair value.

Life Insurance

The carrying amount of life insurance contracts is assumed to be a reasonable fair value. Life insurance contracts are carried on the balance sheet at their redemption value as of June 30, 2010.  This redemption value is based on existing market conditions and therefore represents the fair value of the contract.

Off-Balance-Sheet Items

The carrying amount and estimated fair value of off-balance-sheet items were not material at June 30, 2010 or December 31, 2009.

The carrying amount and estimated fair values of financial instruments as of June 30, 2010 and December 31, 2009 are shown in the table below (in thousands of dollars):

	June 30, 2010				December 31, 2009
	Carrying		Estimated		Carrying		Estimated
	Amount		Fair Value		Amount		Fair Value
Financial Assets:
Cash and due from banks	$	6,710	$	6,710	$	7,062	$	7,062
Interest bearing deposits		1,824		1,824		1,880		1,880
Federal funds sold		7,631		7,631		8,936		8,936
Securities available for sale		30,926		30,926		26,936		26,936
Restricted investments		2,185		2,185		2,185		2,185
Loans, net		327,550		329,068		331,462		332,999
Interest receivable		1,898		1,898		1,908		1,908
Life insurance contracts		6,887		6,887		6,755		6,755
Financial Liabilities:
Demand and savings deposits		128,599		128,599		125,431		125,431
Time deposits		221,021		222,606		224,446		226,057
Overnight and other short term debt instruments		0		0		0		0
Long term debt instruments		10,633		11,481		10,866		11,733
Interest payable		556		556		656		656

NOTE ELEVEN:   SUBSEQUENT EVENTS

The Company has evaluated events and transactions subsequent to June 30, 2010 through the date these consolidated financial statements were issued.  Based on the definitions and requirements of U.S. Generally Accepted Accounting Principles, we have not identified any events that have occurred subsequent to June 30, 2010 through the date these consolidated financial statements were issued that require recognition or disclosure in the consolidated financial statements.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Introduction

The following discussion focuses on significant results of the Company’s operations and significant changes in our financial condition or results of operations for the periods indicated in the discussion. This discussion should be read in conjunction with the preceding financial statements and related notes, as well as the Company’s Annual Report on Form 10-K for the period ended December 31, 2009.  Current performance does not guarantee, and may not be indicative of, similar performance in the future.

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Forward Looking Statements

Certain statements in this report may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.  Forward-looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact.  Such statements are often characterized by the use of qualified words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,” “project,” “anticipate” or other similar words.  Although the Company believes that its expectations with respect to certain forward-looking statements are based upon reasonable assumptions within the bounds of its existing knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements.  Actual future results and trends may differ materially from historical results or those anticipated depending on a variety of factors, including, but not limited to, the effects of and changes in:  general economic conditions, the interest rate environment, legislative and regulatory requirements, competitive pressures, new products and delivery systems, inflation, changes in the stock and bond markets, technology, downturns in the trucking and timber industries, effects of mergers and/or downsizing in the poultry industry in Hardy County, continued challenges in the current economic environment affecting our financial condition and results of operations, continued deterioration in the financial condition of the U.S. banking system impactin g the valuations of investments the Company has made in the securities of other financial institutions, and consumer spending and savings habits, particularly in the current economic environment.  Additionally, actual future results and trends may differ from historical or anticipated results to the extent: (1) any significant downturn in certain industries, particularly the trucking and timber industries are experienced; (2) loan demand decreases from prior periods; (3) the Company may make additional loan loss provisions due to negative credit quality trends in the future that may lead to a deterioration of asset quality; (4) the Company may not continue to experience significant recoveries of previously charged-off loans or loans resulting in foreclosure; (5) the Company is unable to control costs and expenses as anticipated, (6) legislative and regulatory changes could increase expenses (including changes as a result of rules and regulations adopted under the Dodd-Frank Wall Street Reform and C onsumer Protection Act, and (7) any additional assessments imposed by the FDIC. Additionally, consideration should be given to the cautionary language contained elsewhere in this Form 10-Q.  The Company does not update any forward-looking statements that may be made from time to time by or on behalf of the Company.

Critical Accounting Policies

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The financial statements contained within these statements are, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of these transactions would be the same, the timing of events that would impact these transactions could change.

Disclosure of the Company’s significant accounting policies are included in Note Two to the Consolidated Financial Statements of the Company’s Annual Report on Form 10-K for the period ended December 31, 2009. Some of the policies are particularly sensitive, requiring significant judgments, estimates and assumptions by management.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) ASC 450, Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) ASC 310, Loans and Debt Securities Acquired with Deteriorated Credit Quality (previously Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan), which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

The allowance for loan losses includes two basic components: estimated credit losses on individually evaluated loans that are determined to be impaired, and estimated credit losses inherent in the remainder of the loan portfolio. Under GAAP, an individual loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. An individually evaluated loan that is determined not to be impaired is evaluated under ASC 450 when specific characteristics of the loan indicate that it is probable there would be estimated credit losses in a group of loans with those characteristics.

GAAP does not specify how an institution should identify loans that are to be evaluated for collectability, nor does it specify how an institution should determine that a loan is impaired. Each subsidiary of Highlands uses its standard loan

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review procedures in making those judgments so that allowance estimates are based on a comprehensive analysis of the loan portfolio. For loans that are individually evaluated and found to be impaired, the associated allowance is based upon the estimated fair value, less costs to sell, of any collateral securing the loan as compared to the existing balance of the loan as of the date of analysis.

All other loans, including individually evaluated loans determined not to be impaired, are included in a group of loans that are measured under ASC 450 to provide for estimated credit losses that have been incurred on groups of loans with similar risk characteristics. The methodology for measuring estimated credit losses on groups of loans with similar risk characteristics in accordance with ASC 450 is based on each group’s historical net charge-off rate, adjusted for the effects of the qualitative or environmental factors that are likely to cause estimated credit losses as of the evaluation date to differ from the group’s historical loss experience.

Intangible Assets

The Company carries intangible assets related to the purchase of two banks. Amounts paid to purchase these banks were allocated as intangible assets. Generally accepted accounting principles were applied to allocate the intangible components of the purchases. The excess was allocated between identifiable intangibles (core deposit intangibles) and unidentified intangibles (goodwill). Goodwill is required to be evaluated for impairment on an annual basis, and the value of the goodwill adjusted accordingly, should impairment be found.  As of December 31, 2009, the Company did not identify an impairment of this intangible. In addition to the intangible assets associated with the purchases of banks, the company also carries intangible assets relating to the purchase of naming rights to certain features of a performing arts center in Petersburg, WV. Intangible assets other than goodwill, which are determined to have finite lives, are amortized based upon the estimated economic benefits received.

Post Retirement Benefits and Life Insurance Investments

The Company has invested in and owns life insurance policies on key officers. The policies are designed so that the company recovers the interest expenses associated with carrying the policies and the officer will, at the time of retirement, receive any earnings in excess of the amounts earned by the Company. The Company recognizes as an asset the net amount that could be realized under the insurance contract as of the balance sheet date. This amount represents the cash surrender value of the policies less applicable surrender charges. The portion of the benefits, which will be received by the executives at the time of their retirement, is considered, when taken collectively, to constitute a retirement plan. Therefore the Company accounts for these policies using guidance found in ASC 715, Compensation –Retirement Benefits.  ASC 715 requires that an employer’s obligation under a deferred compensation agreement be accrued over the expected service life of the employee through their normal retirement date. Assumptions are used in estimating the present value of amounts due officers after their normal retirement date.  These assumptions include the estimated income to be derived from the investments and an estimate of the Company’s cost of funds in these future periods.  In addition, the discount rate used in the present value calculation will change in future years based on market conditions.

Adoption of New Accounting Standards

In June 2009, FASB issued new accounting guidance related to U.S. GAAP (FASB ASC 105, Generally Accepted Accounting Principles).  This guidance establishes FASB ASC as the source of authoritative U.S. GAAP recognized by FASB to be applied by nongovernmental entities.  Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative U.S. GAAP for SEC registrants.  FASB ASC supersedes all existing non-SEC accounting and reporting standards.  All other non-grandfathered, non-SEC accounting literature not included in FASB ASC has become non-authoritative.  FASB will no longer issue new standards in the form of Statements, FASB Staff Positions or Emerging Issues Task Force Abstracts.  Instead, it will issue Accounting Standards Updates (ASUs), which will serve to update FASB ASC, provide background information about the guidance and provide the basis for conclusions on the changes to FASB ASC.  FASB ASC is not intended to change U.S. GAAP or any requirements of the SEC.

The Company adopted new guidance impacting Financial Accounting Standards Board Topic 805: Business Combinations (Topic 805) on January 1, 2009. This guidance requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition); establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; requires expensing of most transaction and restructuring costs; and requires the acquirer to disclose to investors and other users all of the information needed to evaluate and understand the nature and financial effect of the business combination. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In April 2009, the FASB issued new guidance impacting Topic 805. This guidance addresses application issues raised by preparers, auditors, and members of the legal profession on initial recognition and measurement, subsequent measurement and accounting, and disclosure of assets and liabilities arising from contingencies in a business combination. This

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guidance was effective for business combinations entered into on or after January 1, 2009. This guidance did not have a material impact on the Company’s consolidated financial statements.

In December 2008, the FASB issued new guidance impacting FASB Topic 715-20: Compensation Retirement Benefits – Defined Benefit Plans – General. The objectives of this guidance are to provide users of the financial statements with more detailed information related to the major categories of plan assets, the inputs and valuation techniques used to measure the fair value of plan assets and the effect of fair value measurements using significant unobservable inputs (Level 3) on changes in plan assets for the period, as well as how investment allocation decisions are made, including the factors that are pertinent to an understanding of investment policies and strategies. The disclosures about plan assets required by this guidance are included in Note fifteen of the Company’s consolidated financial statements included in th e Company’s Annual Report on Form 10-K for the period ended December 31, 2009.

In April 2009, the FASB issued new guidance impacting FASB Topic 820: Fair Value Measurements and Disclosures (Topic 820). This interpretation provides additional guidance for estimating fair value when the volume and level of activity for the asset or liability have significantly decreased. This also includes guidance on identifying circumstances that indicate a transaction is not orderly and requires additional disclosures of valuation inputs and techniques in interim periods and defines the major security types that are required to be disclosed. This guidance was effective for interim and annual periods ending after June 15, 2009, and should be applied prospectively. The adoption of the standard did not have a material impact on the Company’s consolidated financial statements.

In April 2009, the FASB issued new guidance impacting FASB Topic 320-10: Investments – Debt and Equity Securities. This guidance amends GAAP for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. This guidance was effective for interim and annual periods ending after June 15, 2009, with earlier adoption permitted for periods ending after March 15, 2009. The Company did not have any cumulative effect adjustment related to the adoption of this guidance.

In May 2009, the FASB issued new guidance impacting FASB Topic 855: Subsequent Events. This update provides guidance on management’s assessment of subsequent events that occur after the balance sheet date through the date that the financial statements are issued. This guidance is generally consistent with current accounting practice. In addition, it requires certain additional disclosures. This guidance was effective for periods ending after June 15, 2009 and had no impact on the Company’s consolidated financial statements.

In August 2009, the FASB issued new guidance impacting Topic 820. This guidance is intended to reduce ambiguity in financial reporting when measuring the fair value of liabilities. This guidance was effective for the first reporting period (including interim periods) after issuance and had no impact on the Company’s consolidated financial statements.

In September 2009, the FASB issued new guidance impacting Topic 820. This creates a practical expedient to measure the fair value of an alternative investment that does not have a readily determinable fair value. This guidance also requires certain additional disclosures. This guidance is effective for interim and annual periods ending after December 15, 2009. The Company does not expect the adoption of the new guidance to have a material impact on its consolidated financial statements

In October 2009, the Securities and Exchange Commission issued Release No. 33-99072, Internal Control over Financial Reporting in Exchange Act Periodic Reports of Non-Accelerated Filers. Release No. 33-99072 delays the requirement for non-accelerated filers to include an attestation report of their independent auditor on internal control over financial reporting with their annual report until the fiscal year ending on or after June 15, 2010.

In January 2010, the FASB issued ASU 2010-02, Consolidation (Topic 810): Accounting and reporting for Decreases in Ownership of a Subsidiary – a Scope Clarification. ASU 2010-02 amends Subtopic 810-10 to address implementation issues related to changes in ownership provisions including clarifying the scope of the decrease in ownership and additional disclosures.  ASU 2010-02 is effective beginning in the period that an entity adopts Statement 160.  If an entity has previously adopted Statement 160, ASU 2010-02 is effective beginning in the first interim or annual reporting period ending on or after December 15, 2009 and should be applied retrospectively to the first period Statement 160 was adopted.   The adoption of ASU 2010-02 did not have a material impact on the Company’s consolidated financial statements.

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In June 2009, the FASB issued new guidance relating to the accounting for transfers of financial assets. The new guidance, which was issued as SFAS No. 166, Accounting for Transfers of Financial Assets, an amendment to SFAS No. 140, was adopted into Codification in December 2009 through the issuance of Accounting Standards Updated ASU 2009-16. The new standard provides guidance to improve the relevance, representational faithfulness, and comparability of the information that an entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets.  The adoption of the standard did not have a material impact on the Company’s consol idated financial statements.

In June 2009, the FASB issued new guidance relating to the variable interest entities.  The new guidance, which was issued as SFAS No. 167, Amendments to FASB Interpretation No. 46(R), was adopted into Codification in December 2009. The objective of the guidance is to improve financial reporting by enterprises involved with variable interest entities and to provide more relevant and reliable information to users of financial statements. SFAS No. 167 is effective as of January 1, 2010. The adoption of the standard did not have a material impact on the Company’s consolidated financial statements.

In October 2009, the FASB issued ASU 2009-15, Accounting for Own-Share Lending Arrangements in Contemplation of Convertible Debt Issuance or Other Financing. ASU 2009-15 amends Subtopic 470-20 to expand accounting and reporting guidance for own-share lending arrangements issued in contemplation of convertible debt issuance. ASU 2009-15 is effective for fiscal years beginning on or after December 15, 2009 and interim periods within those fiscal years for arrangements outstanding as of the beginning of those fiscal years. The adoption of ASU 2009-15 did not have a material impact on the Company’s consolidated financial statements.

In January 2010, the FASB issued ASU 2010-04, Accounting for Various Topics – Technical Corrections to SEC Paragraphs. ASU 2010-04 makes technical corrections to existing SEC guidance including the following topics: accounting for subsequent investments, termination of an interest rate swap, issuance of financial statements - subsequent events, use of residential method to value acquired assets other than goodwill, adjustments in assets and liabilities for holding gains and losses, and selections of discount rate used for measuring defined benefit obligation. The adoption of ASU 2010-04 did not have a material impact on the Company’s consolidated financial statements.

In January 2010, the FASB issued ASU 2010-05, Compensation – Stock Compensation (Topic 718): Escrowed Share Arrangements and the Presumption of Compensation. ASU 2010-05 updates existing guidance to address the SEC staff’s views on overcoming the presumption that for certain shareholders escrowed share arrangements represent compensation.  The Company does not expect the adoption of ASU 2010-05 to have a material impact on its consolidated financial statements.

In January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new disclosures, and includes conforming amendments to guidance on employers’ disclosures about postretirement benefit plan assets. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years.  The Company does not expect the adoption of ASU 2010-06 to have a material impact on its consolidat ed financial statements.

In February 2010, the FASB issued ASU 2010-08, Technical Corrections to Various Topics. ASU 2010-08 clarifies guidance on embedded derivatives and hedging. ASU 2010-08 is effective for interim and annual periods beginning after December 15, 2009. The adoption of ASU 2010-08 did not have a material impact on the Company’s consolidated financial statements.

In February 2010, the FASB issued Accounting Standards Update No. 2010-09, “Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements.”  ASU 2010-09 addresses both the interaction of the requirements of Topic 855 with the SEC’s reporting requirements and the intended breadth of the reissuance disclosures provisions related to subsequent events.  An entity that is an SEC filer is not required to disclose the date through which subsequent events have been evaluated.  ASU 2010-09 is effective immediately.The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In July 2010, the FASB issued ASU 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.”  The new disclosure guidance will significantly expand the existing requirements and will lead to greater transparency into a company’s exposure to credit losses from lending arrangements.  The extensive new disclosures of information as of the end of a reporting period will become effective for both interim and annual reporting periods ending after December 31, 2010.  Specific items regarding activity that occurred before the issuance of the ASU, such as the allowance roll forward and modification disclosures, will be required for periods beginning after December 31, 2010.  The Company is currently assessing the impact that ASU 2010-20 will have on its consolidated financial statements.

Overview of First Six Months Results

Net income for the first six months of 2010, as compared to the same period in 2009, decreased by 75.9% driven primarily by increased provision for loan loss expense.

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Total assets decreased 0.17% from December 31, 2009 to June 30, 2010 with gross loan balances decreasing 0.75% from December 31, 2009. Although average balances of earning assets for the first six months of 2010 were 4.44% higher than for the same period in 2009, average balances of interest bearing liabilities increased 7.01% for the same comparative time period, which contributed largely to the 0.43% decrease in net interest income.

The Company’s allowance for loan losses increased to 1.63% of total gross loans during the first six months of 2010 as compared to 1.20% the same period in 2009.  The increase is driven by the changes in loan loss experience factors which have increased as a result of the current economic conditions.

Non-interest income decreased $80,000 in the first six months of 2010 as compared to the same period in 2009 driven primarily by the shift in income associated with fee income and security transactions.

Non-interest expense increased $399,000 in the first six months of 2010 as compared to the same period in 2009 primarily due to increases in FDIC premiums, increases in data processing costs, and increases in employee related costs.

Performance Measures

The following table compares selected commonly used measures of bank performance for the six month periods ended June 30, 2010 and 2009:

	Six months ended
	June 30,
	2010			2009
Annualized return on average assets		0.19	%		0.83	%
Annualized return on average equity		1.95	%		8.08	%
Net interest margin (1)		4.35	%		4.56	%
Efficiency Ratio (2)		69.06	%		64.07	%
Earnings per share (3)	$	0.29		$	1.21

(1) On a fully taxable equivalent basis and including loan origination fees.

(2) Non-interest expenses for the period indicated divided by the sum of net interest income and non-interest income for the period indicated.

(3) Per weighted average shares of common stock outstanding for the period indicated.

Securities Portfolio

The Company's securities portfolio serves several purposes.  Portions of the portfolio are used to secure certain public and trust deposits.  The remaining portfolio is held as investments or used to assist the Company in liquidity and asset liability management.  Total securities, including restricted securities, represented 8.13% of total assets and 80.64% of total shareholders’ equity at June 30, 2010.

The securities portfolio typically will consist of three components:  securities held to maturity, securities available for sale and restricted securities.  Securities are classified as held to maturity when management has the intent and the Company has the ability at the time of purchase to hold the securities to maturity.  Held to maturity securities are carried at cost, adjusted for amortization of premiums and accretion of discounts. Securities to be held for indefinite periods of time are classified as available for sale and accounted for at market value.  Securities available for sale include securities that may be sold in response to changes in market interest rates, changes in the security's prepayment risk, increases in loan demand, general liquidity needs and other similar factors.  ; Restricted securities are those investments purchased as a requirement of membership in certain governmental lending institutions and cannot be transferred without the issuer’s permission.  The Company's purchases of securities have generally been limited to securities of high credit quality with short to medium term maturities.

The Company identifies at the time of acquisition those securities that are available for sale. These securities are valued at their market value with any difference in market value and amortized cost shown as an adjustment in stockholders' equity.  Changes in market values of securities which are considered temporary changes due to changes in the market rate of interest are reflected as changes in other comprehensive income, net of the deferred tax effect.  Any changes in market values of securities deemed by management to be attributable to reasons other than changes in market rates of interest would be recorded through results of operations.   As of June 30, 2010, management determined that all securities with fair values less than the amortized cost, are related to increases in the current interes t rates for similar issues of securities, and that no other than temporary impairment for any securities in the portfolio exists because of downgrades of the securities or as a result of a change in the financial condition of any of the issuers. A summary of the length of time of unrealized losses for all securities held at June 30, 2010 can be found in Note Five to the financial statements. Management reviews all

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securities with unrealized losses, and all securities in the portfolio on a regular basis to determine whether the potential for other than temporary impairment exists.

Loan Portfolio

The Company is an active residential mortgage and construction lender and generally extends commercial loans to small and medium sized businesses within its primary service area.  The Company's commercial lending activity extends across its primary service areas of Grant, Hardy, Hampshire, Mineral, Randolph, Tucker, and northern Pendleton counties in West Virginia, Frederick County, Virginia and Garrett County, Maryland.  Consistent with its focus on providing community-based financial services, the Company does not attempt to diversify its loan portfolio geographically by making significant amounts of loans to borrowers outside of its primary service area.

Credit Quality and Allowance for Loan Losses

Non-performing loans increased 69.72% from December 31, 2009 to June 30, 2010 primarily as a result of increases in non-accrual and restructured loans somewhat offset by a decrease in loans past due in excess of 90 days.  Non-accrual loans have increased as a result of the continued deterioration of loan performance due to the current economic conditions.  As a result of the continuing decline of property values, management has chosen to be more conservative in its evaluation of potential non-performing loans.  Borrowers of restructured credits are performing in accordance with the revised terms of their contracts.  Based on Management’s analysis, these loans are well secured and no losses are anticipated; therefore, no additional allowance was provided for these restructured credits.     Non-performing loans represented as a percentage of total loans increased to 3.36% during the first six months of 2010 primarily due to the increase in non-accrual and restructured loans mentioned above.  The allowance for loan losses as a percentage of total loans increased from the December 31, 2009 level of 1.20% to 1.63%.  As noted in Note Three to the unaudited consolidated financial statements, the carrying value of impaired loans increased from $3.4 million at December 31, 2009 to $9.3 million at June 30, 2010.

Each of the Company’s banking subsidiaries determines the adequacy of its allowance for loan losses independently using the same allowance for loan loss methodology.  The allowance is calculated quarterly and adjusted prior to the issuance of the quarterly financial statements.  All loan losses charged to the allowance are approved by the boards of directors of each bank at their regular meetings.  The allowance is reviewed for adequacy after considering historical loss rates, current economic conditions (both locally and nationally) and any known credit problems that have not been considered elsewhere in the calculation.  Although the loan portfolios of the two banks are similar to each other, some differences exist which result in divergent risk patterns and different historical charge-of f rates amongst the functional areas of the banks’ loan portfolios.  Each bank pays particular attention to the individual loan performance, collateral values, borrower financial condition and economic conditions.  A committee, with representatives from both subsidiary banks, meets to discuss the overall economic conditions that impact both subsidiary banks in the same fashion.

The determination of an adequate allowance at each bank is done in a three step process.  The first step is to identify impaired loans.  Impaired loans are problem loans above a certain threshold which have estimated losses calculated based on collateral values and projected cash flows.  Impaired loans and their resulting valuation allowance are disclosed in Note Three to the Company’s unaudited consolidated financial statements.  The second step is to identify loans above a certain threshold which are problem loans due to the borrower’s payment history or deteriorating financial condition.  Losses in this category are determined based on historical loss rates adjusted for current economic conditions.  The final step is to calculate a loss for the remainder of the portfolio using historical loss information for each type of loan classification.  The determination of specific allowances and weighting is subjective and actual losses may be greater or less than the current amount of the allowance.  However, Management believes the current level of the allowance for loan losses represents a fair assessment of the losses inherent in the loan portfolio.

The following table illustrates certain ratios related to quality of the Company’s loan portfolio:

	June 30, 2010			December 31, 2009
Allowance for loan losses as a percentage of gross loans		1.63	%		1.20	%
Non performing loans as a percentage of gross loans		3.36	%		1.97	%
Ratio of allowance for loan losses to non-performing loans		0.48			0.61

Non-performing loans include non-accrual loans, loans 90 days or more past due and still accruing interest, and restructured loans.  Non-accrual loans are loans on which interest accruals have been suspended.  Loans are typically placed on non-accrual status once they have reached certain delinquency status, depending on loan type, and it is no longer reasonable to expect collection of principal and interest because collateral is insufficient to cover both the principal and interest due.  After loans are placed on non-accrual status, they are returned to accrual status if the obligation is brought current by the borrower, or they are charged off if payment is not made.  Restructured loans are loans on which the original interest rate or repayment terms have been changed due to financial hardship of the borrower.  The following table summarizes the Company’s non-performing loans at June 30, 2010 and December 31, 2009 (in thousands of dollars):

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	June 30, 2010		December 31, 2009
Non-accrual loans	$	5,412	$	2,567
Loans past due 90 days and still accruing interest		860		2,192
Restructured Loans		4,921		1,836
Total non-performing loans	$	11,193	$	6,595

The following table summarizes the Company’s net charge-offs by loan type for the six month periods ended June 30, 2010 and 2009 (in thousands of dollars):

	2010			2009
Charge-offs
Commercial	$	(272	)	$	(226	)
Mortgage and construction		(567	)		(246	)
Consumer		(345	)		(411	)
Total Charge-offs	$	(1,184	)	$	(883	)
Recoveries
Commercial	$	58		$	1
Mortgage		27			25
Consumer		189			105
Total Recoveries		274			131
Total Net Charge-offs	$	(910	)	$	(752	)

Management believes that the allowance is to be taken as a whole, and the allocation between loan types is an estimation of potential losses within each type given information known at the time.  The following table shows the allocation for loans in the loan portfolio and the corresponding amounts of the allowance allocated by loan type as of June 30, 2010 and December 31, 2009 (in thousands of dollars):

	June 30, 2010					December 31, 2009
	Amount		Percent			Amount		Percent
			of Loans					of Loans
Loan Type
Commercial-Mortgage	$	1,899		42	%	$	1,314		39	%
Commercial-Other		372		5	%		340		4	%
Consumer-Mortgage		1,616		44	%		1,051		45	%
Consumer-Other		1,529		9	%		1,316		12	%
Totals	$	5,416		100	%	$	4,021		100	%

Because of its large impact on the local economy, management continues to monitor the economic health of the poultry industry. The Company has direct loans to poultry growers and the industry is a large employer in the Company’s trade area. In addition, multiple manufacturers of household cabinetry are large employers in the Company’s primary trade area. Due to the downturn in the housing market nationally, there have been indications that the demand for cabinetry has decreased, impacting the performance of these manufacturers. Because of the impact on the local economy, management has begun to monitor the performance of this industry as it relates to local employment trends. Additionally, the Company’s loan portfolio contains a segment of loans collateralized by heavy equipment, particularly in the trucking, mining a nd timber industries. Because of the impact of the slowing economic conditions on the housing market, the timber sector has experienced a recent downturn. While the Company has experienced some losses related to the downturn in this industry, no material losses related to foreclosures of loans collateralized by assets typical to the timber harvest industry have occurred.  This industry has begun to recover over the past two quarters resulting in reduced financial stresses on the Company’s borrowers.

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Net Interest Income

The Company’s net interest income, on a fully taxable equivalent basis, decreased 0.43% for the first six months of 2010 as compared to the same period in 2009 as average balances of earning assets increased 4.44% as compared to a 7.01% increase in the average balances of interest bearing liabilities.

Decreases during recent years in the target rate for federal funds sold have caused overall rates on both interest bearing liabilities and earning assets to decrease. These effects are still being seen in the Company’s net interest income as variable loans reprice and older balances of other earning assets and interest bearing liabilities mature and are replaced with new assets and liabilities at lower rates.

Also, the Company has recently placed larger balances of loans into non-accrual status than have been placed there historically. This, combined with increases in balances of Other Real Estate Owned due to foreclosures, has had a negative impact on interest income.

The table below illustrates the effects on net interest income, on a fully taxable equivalent basis, and for the first six months of each year, of changes in average volumes of interest bearing liabilities and earning assets from 2009 to 2010 and changes in average rates on interest bearing liabilities and earning assets from 2009 to 2010 (in thousands of dollars):

Changes for the second quarter 2010 compared to the second quarter 2009 are similar to those described above for the six month periods.

EFFECT OF RATE-VOLUME CHANGES ON NET INTEREST INCOME

Increase (Decrease) Six Months Ended June 30, 2010 Compared to Six Months Ended June 30, 2009

	Due to change in:
	Average
	Volume			Average Rate			Total Change
Interest Income
Loans	$	139		$	(728	)	$	(589	)
Federal funds sold		3			(2	)	$	1
Interest bearing deposits		2			(5	)	$	(3	)
Taxable investment securities		82			(142	)	$	(60	)
Nontaxable investment securities		0			(28	)	$	(28	)
Total Interest Income	$	226		$	(905	)	$	(679	)
Interest Expense
Demand deposits	$	0		$	(10	)	$	(10	)
Savings deposits		8			(13	)		(5	)
Time deposits		252			(851	)		(599	)
Borrowings		(77	)		47			(30	)
Total Interest Expense	$	183		$	(827	)	$	(644	)
Net Interest Income	$	43		$	(78	)	$	(35	)

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The table below sets forth an analysis of net interest income for the six month periods ended June 30, 2010 and 2009 (Average balances and interest/expense shown in thousands of dollars):

	2010								2009
	Average			Income/					Average			Income/
	Balance			Expense		Rate			Balance			Expense		Rate
Earning Assets
Loans	$	333,736		$	11,112		6.66	%	$	329,571		$	11,701		7.10	%
Taxable investment securities		24,984			312		2.50	%		18,416			372		4.04	%
Non-taxable investment securities		3,650			87		4.77	%		3,645			115		6.31	%
Interest bearing deposits		2,883			3		0.21	%		509			6		2.40	%
Federal funds sold		11,359			10		0.18	%		8,456			9		0.21	%
Total Earning Assets		376,612			11,524		6.12	%		360,597			12,203		6.77	%
Allowance for loan losses		(4,207	)							(3,704	)
Other non-earning assets		38,239								35,393
Total Assets	$	410,644							$	392,286
Interest Bearing Liabilities
Demand deposits	$	23,157		$	14		0.12	%	$	22,447		$	24		0.21	%
Savings deposits		52,790			94		0.36	%		48,506			99		0.41	%
Time deposits		223,668			2,988		2.67	%		204,835			3,587		3.50	%
Long-term debt		10,752			239		4.45	%		14,236			269		3.78	%
Total Interest Bearing Liabilities		310,367			3,335		2.15	%		290,024			3,979		2.74	%
Demand deposits		53,129								49,451
Other liabilities		9,160								12,650
Stockholders’ equity		37,988								40,161
Total liabilities and stockholders’ equity	$	410,644							$	392,286
Net Interest Income				$	8,189							$	8,224
Net Yield on Earning Assets							4.35	%							4.56	%

Notes:

Yields are computed on a taxable equivalent basis using a 29% tax rate

Average balances are based upon daily balances

Includes loans in non-accrual status

Income on loans includes fees

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The table below sets forth an analysis of net interest income for the three month periods ended June 30, 2010 and 2009 (Average balances and interest/expense shown in thousands of dollars):

	2010								2009
	Average			Income/					Average			Income/
	Balance			Expense		Rate			Balance			Expense		Rate
Earning Assets
Loans	$	333,246		$	5,629		6.76	%	$	329,930		$	5,811		7.05	%
Taxable investment securities		26,271			158		2.41	%		19,730			180		3.65	%
Non-taxable investment securities		3,431			41		4.78	%		4,044			60		5.91	%
Interest bearing deposits		3,614			1		0.11	%		471			3		2.99	%
Federal funds sold		11,205			5		0.18	%		8,697			4		0.19	%
Total Earning Assets		377,767			5,834		6.18	%		362,872			6,058		6.68	%
Allowance for loan losses		(4,458	)							(3,722	)
Other non-earning assets		37,926								38,823
Total Assets	$	411,235							$	397,973
Interest Bearing Liabilities
Demand deposits	$	23,313		$	7		0.12	%	$	22,430		$	11		0.20	%
Savings deposits		53,901			49		0.36	%		49,071			45		0.36	%
Time deposits		223,107			1,434		2.57	%		207,162			1,816		3.51	%
Long-term debt		10,692			124		4.64	%		11,172			132		4.72	%
Total Interest Bearing Liabilities		311,013			1,614		2.08	%		289,835			2,004		2.77	%
Demand deposits		53,766								49,831
Other liabilities		8,548								17,724
Stockholders’ equity		37,908								40,583
Total liabilities and stockholders’ equity	$	411,235							$	397,973
Net Interest Income				$	4,220							$	4,054
Net Yield on Earning Assets							4.47	%							4.47	%

Notes:

Yields are computed on a taxable equivalent basis using a 29% tax rate

Average balances are based upon daily balances

Includes loans in non-accrual status

Income on loans includes fees

Non-interest Income

Non-interest income decreased $80,000, or 6.97%, during the first six months of 2010 compared to the same period in 2009 driven primarily by the shift in income associated with fee income and security transactions.

Service charges on deposit accounts decreased 6.33%. The largest portion of these charges is non-sufficient funds fees on non-interest bearing transaction accounts. The subsidiary banks continued to see decreases in service charges associated with the program commonly referred to as the “courtesy overdraft” program.

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Life insurance investment income increased 7.32% during the first six months of 2010 compared to the same period in 2009 as a result of an adjustment to the income projection accrual for 2010 to be more in line with prior year’s annual income.

The quarter-to-quarter comparisons are primarily due to the same items as described above.

Non-interest Expense

Non-interest expense increased 6.68% for the first six months of 2010 as compared to the same period in 2009.

Changes in salary and benefits expense

The following table compares the components of salary and benefits expense for the six month periods ended June 30, 2010 and 2009 (in thousands of dollars):

Salary and Benefits Expense

	2010		2009		Increase (Decrease)
Employee salaries	$	2,223	$	2,154	$	69
Employee benefit insurance		526		464		62
Payroll taxes		199		192		7
Post retirement plans		497		447		50
Total	$	3,445	$	3,257	$	188

The table below illustrates the change in salary expense for the first six months of 2010 as compared to the same period in 2009 occurring because of increases in average pay per employee and increases in the average number of full time employees (in thousands of dollars):

	Amount
Changes due to adjustment in average salary per full time equivalent employee	$	87
Changes due to fluctuations in the average full time equivalent employees for the periods		(18	)
Total increase in salary expense	$	69

Quarter-to-quarter comparisons are similar to the change described above for the first six months of 2010 compared to the first six months of 2009.

Changes in data processing expense

Data processing expense increased 60.77% or $206,000 for the first six months of 2010 compared to the same period in 2009.  During 2009, the Company completed the installation of its new core data processing system. During the negotiations for the new system, the vendor provided incentives in the form of credits for the Company’s then current contractual arrangements. This contributed significantly to the decline in data processing costs during 2009. The expiration of this monthly credit at the end of November 2009 coupled with a change in classification of ATM processing fees resulted in the increase.  Prior to the implementation of the new system all ATM processing costs were classified as other non-interest expenses.

Quarter-to-quarter comparisons are similar to the change described above for the first six months of 2010 compared to the first six months of 2009.

Changes in occupancy and equipment expense

The following table illustrates the components of occupancy and equipment expense for the six month periods ended June 30, 2010 and 2009 (in thousands of dollars):

	2010		2009		Increase (Decrease)
Depreciation of buildings and equipment	$	372	$	321	$	51
Maintenance expense on buildings and equipment		197		199		(2	)
Utilities expense		69		68		1
Real estate and personal property tax		44		44		0
Other expense related to occupancy and equipment		46		40		6
Total occupancy and equipment expense	$	728	$	672	$	56

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The increases in depreciation costs are associated with the aforementioned investment in the new core data processing system implemented in November 2009.

Quarter-to-quarter comparisons are similar to the change described above for the first six months of 2010 compared to the first six months of 2009.

Changes in other non-interest expense

Other non-interest expense decreased $143,000 or 11.04% during the first six months of 2010 compared to the same period in 2009.  The primary driver of the decrease is the result of the reclassification of ATM costs from other non-interest expenses to data processing expenses.

The table below illustrates components of other non-interest expense for the six month periods ended June 30, 2010 and 2009 (in thousands of dollars). Significant individual components of other non-interest expense are itemized.

	2010			2009		Increase (Decrease)
Office supplies and postage & freight expense	$	210		$	248	$	(38	)
FDIC Premiums		326			313		13
ATM expense		(30	)		107		(137	)
Amortization of intangible assets		97			97		0
Advertising and marketing expense		75			77		(2	)
Miscellaneous components of other non interest expense		474			453		21
Total	$	1,152		$	1,295	$	(143	)

Quarter-to-quarter comparisons are similar to the change described above for the first six months of 2010 compared to the first six months of 2009.

Borrowed Funds

The Company borrows funds from the Federal Home Loan Bank (“FHLB”) to reduce market rate risks or to provide operating liquidity.  Management typically will initiate these borrowings in response to a specific need for managing market risks or for a specific liquidity need and will attempt to match features of these borrowings to best suit the specific need. Therefore, the borrowings on the Company’s balance sheet as of June 30, 2010 and throughout the periods ended June 30, 2010 and December 31, 2009 have varying features of amortization or single payment with periodic, regular interest payment and also have interest rates which vary based on the terms and on the features of the specific borrowing.

Liquidity

Operating liquidity is the ability to meet present and future financial obligations. Short term liquidity is provided primarily through cash balances, deposits with other financial institutions, federal funds sold, non-pledged securities and loans maturing within one year. Additional sources of liquidity available to the Company include, but are not limited to, loan repayments, the ability to obtain deposits through the adjustment of interest rates and the purchasing of federal funds.  To further meet its liquidity needs, the Company also maintains lines of credit with correspondent financial institutions, the Federal Reserve Bank of Richmond and the Federal Home Loan Bank of Pittsburgh.

Historically, the Company’s primary need for additional levels of operational liquidity has been to fund increases in loan balances. The Company has normally funded increases in loans by increasing deposits and with decreases in liquid assets such as balances of federal funds sold and balances of securities. The Company also utilizes existing borrowing facilities for additional levels of operating liquidity. In choosing which sources of operating liquidity to utilize, management evaluates the implications of each liquidity source and its impact on profitability, balance sheet stability and potential future liquidity needs.

The parent Company’s operating funds, funds with which to pay shareholder dividends and funds for the exploration of new business ventures have been supplied primarily through dividends paid by the Company’s subsidiary banks Capon Valley Bank (CVB) and The Grant County Bank (GCB).  The various regulatory authorities impose restrictions on dividends paid by a state bank.  A state bank cannot pay dividends without the consent of the relevant banking authorities

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in excess of the total net profits of the current year and the combined retained profits of the previous two years.  As of June 30, 2010, the subsidiary banks could pay dividends to Highlands Bankshares, Inc. of approximately $2,193,000 without permission of the regulatory authorities.

Capital

The Company seeks to maintain a strong capital base to expand facilities, promote public confidence, support current operations and grow at a manageable level.  As of June 30, 2010, the Company was above the regulatory minimum levels of capital. The table below summarizes the capital ratios for the Company and its subsidiary banks as of June 30, 2010 and December 31, 2009:

	June 30, 2010						December 31, 2009
	Actual			Regulatory			Actual			Regulatory
	Ratio			Minimum			Ratio			Minimum
Total Risk Based Capital Ratio
Highlands Bankshares		14.27	%		8.00	%		14.33	%		8.00	%
Capon Valley Bank		12.35	%		8.00	%		12.86	%		8.00	%
The Grant County Bank		14.43	%		8.00	%		14.12	%		8.00	%
Tier 1 Leverage Ratio
Highlands Bankshares		9.71	%		4.00	%		9.81	%		4.00	%
Capon Valley Bank		8.10	%		4.00	%		8.38	%		4.00	%
The Grant County Bank		9.95	%		4.00	%		9.91	%		4.00	%
Tier 1 Risk Based Capital Ratio
Highlands Bankshares		13.02	%		4.00	%		13.08	%		4.00	%
Capon Valley Bank		11.08	%		4.00	%		11.60	%		4.00	%
The Grant County Bank		13.18	%		4.00	%		12.89	%		4.00	%

Effects of Inflation

Inflation primarily affects industries having high levels of property, plant and equipment or inventories. Although the Company is not significantly affected in these areas, inflation does have an impact on the growth of assets.  As assets grow rapidly, it becomes necessary to increase equity capital at proportionate levels to maintain the appropriate equity to asset ratios.  Traditionally, the Company's earnings and high capital retention levels have enabled the Company to meet these needs. The Company's reported earnings results have been minimally affected by inflation.  The different types of income and expense are affected in various ways.  Interest rates are affected by inflation, but the timing and magnitude of the changes may not coincide with changes in the consumer price index. 
60;Management actively monitors interest rate sensitivity in order to minimize the effects of inflationary trends on interest rates. Other areas of non-interest expenses may be more directly affected by inflation.

Item 3.Quantitative and Qualitative Disclosures About Market Risk                                                                                        0;                   

Not required for smaller reporting companies.

Item 4.Controls and Procedures

The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of June 30, 2010. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective as of June 30, 2010. The Company has established procedures undertaken during the normal course of business in an effort to reasonably ensure that fraudulent activity of either an amount material to these results or in any amount is not occurring.

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Changes in Internal Controls

During the period reported upon, there were no significant changes in internal controls of Highlands Bankshares, Inc. pertaining to its financial reporting and control of its assets or in other factors that materially affected or are reasonably likely to materially affect such control.

PART IIOTHER INFORMATION

Item 1. Legal Proceedings

Management is not aware of any material pending or threatened litigation in which the Company or its subsidiaries may be involved as a defendant.  In the normal course of business, the banks periodically must initiate suits against borrowers as a final course of action in collecting past due loans. In addition, to management’s knowledge, no governmental authorities have initiated or contemplated legal action against the Company.

Item 1A. Risk Factors

Not required for smaller reporting companies.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None

Item 3. Defaults Upon Senior Securities

None

Item 4. (Removed and Reserved)

None

Item 5. Other Information

None

Item 6. Exhibits

EXHIBIT INDEX
Exhibit
Number	Description
3(i)	Articles of Incorporation of Highlands Bankshares, Inc., as restated, are hereby incorporated by reference to Exhibit 3(i) to Highlands Bankshares Inc.’s Form 10-Q filed November 13, 2007.
3(ii)	Amended Bylaws of Highlands Bankshares, Inc. are incorporated by reference to Exhibit 3(ii) to Highlands Bankshares Inc.’s Report on Form 8-K filed January 9, 2008.
31.1	Certification of Chief Executive Officer Pursuant to section 302 of the Sarbanes-Oxley  Act  of
	2002 Chapter 63, Title 18 USC Section 1350 (A) and (B).
31.2	Certification of Chief Financial Officer  Pursuant to section 302 of the Sarbanes-Oxley  Act of
	2002 Chapter 63, Title 18 USC Section 1350 (A) and (B).
32.1	Statement of Chief Executive Officer Pursuant to 18  U.S.C. §1350.
32.2	Statement of Chief Financial Officer Pursuant to 18 U.S.C. §1350.

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Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	HIGHLANDS BANKSHARES, INC.
	/s/ C.E. Porter
	C.E. Porter
	President & Chief Executive Officer
	/s/ Jeffrey B. Reedy
	Jeffrey B. Reedy
	Chief Financial Officer
August 13, 2010

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